How Fannie Mae, Freddie Mac affect the market

WASHINGTON -- Fannie Mae and Freddie Mac are giants of the mortgage finance industry. But to investors, they're rapidly shrinking.

And as they struggle, they're taking the housing market with them, reinforcing a downward spiral in which their troubles translate into pricier home loans and increasing foreclosures, in turn further undermining the companies.

"Right now you have a giant negative feedback loop," said Paul Miller, an industry analyst at Friedman, Billings, Ramsey Group. "How you break it, I don't know."

About 70 percent of newly issued mortgages are owned or guaranteed by Fannie Mae and Freddie Mac. Without this financial backing, the banks and other lenders who typically make home loans would no longer be able to do so. The housing market could collapse.

The two companies have tried to keep providing financing to the industry but their mounting losses, rooted in the subprime mortgage crisis, are making this harder and harder. Many prospective home buyers are stuck.

"Fewer people are willing to buy property, which contributes to a decline in housing prices and that leads to more foreclosures and higher losses, which hurts Fannie Mae and Freddie Mac, which pull back by tightening their mortgage terms, thus continuing the cycle," said Robert Litan, an economist at the Brookings Institution.

Moody's Economy.com estimates that interest rates on 30-year fixed mortgages are already higher by at least a half percentage point -- and maybe a full percentage point -- because Fannie Mae and Freddie Mac have been forced to pay a premium interest rate on the money they borrow from investors worried about the firms' health.

The yield on bonds guaranteed by the companies has increased to almost the highest in 22 years relative to Treasurys, according to Bloomberg News. And when Fannie Mae and Freddie Mac pay more to borrow that money so they can acquire or guarantee mortgages, the companies pass the cost on mortgage lenders, who in turn charge borrowers more for home loans.

Despite the Federal Reserve's effort to lower interest rates, including repeated cuts over the last year in the interest rate the Fed controls, 30-year, fixed-rate mortgages this week averaged 6.37 percent, the highest level in six years.

At the same time, the companies are tightening credit in an effort to ensure the loans they make will be repaid.

Freddie Mac, for instance, rarely finances no-money-down mortgages, and it doesn't buy or guarantee mortgages given to people who have failed to document their finances. Fannie Mae has withdrawn from the market for Alt-A loans, which are considered risky because they require less documentation than traditional prime loans.

As Fannie Mae and Freddie Mac tighten credit and the cost of borrowing increases, the housing market contracts. For the week that ended Aug. 15, the Mortgage Bankers Association reported that applications for new mortgages declined 34 percent from the year earlier to the lowest level since 2000.

Economy.com projects that this tighter credit alone will account for a 5 percent decrease in housing prices. Overall, Economy.com projects a 30 percent drop in prices.

To sell homes in such a sluggish market, realtors have had to lower prices. When prices fall, homeowners with high mortgage payments tend to walk away from those payments in larger numbers and housing speculators fail at higher rates. Both factors lead to more frequent and more expensive defaults, which hurt Fannie Mae's and Freddie Mac's bottom lines by forcing them to put more money into their capital reserves.

This rise in defaults is a major cause of the companies' net losses, which have been a combined $14.9 billion over the past year.

Those losses reduce investor confidence and compel the firms to be even more conservative about the loans they fund. The vicious cycle starts all over again.

And the red ink is likely to continue. Earlier this month, Freddie Mac reported that its losses from foreclosures and other failed home loans nearly doubled in the second quarter from the previous three months to $2.8 billion, and that the company more than doubled its reserves for anticipated losses because of delinquencies.

One reason: It predicted that national home prices would decline by an average 18 to 20 percent, more than the 15 percent the company had forecast previously.

At Fannie Mae, losses from foreclosures and other problem loans rose to $5.3 billion in the second quarter, from $3.2 billion in the first quarter. And in July, the challenge grew even steeper, said Daniel Mudd, Fannie Mae's chief executive. A market that "many of us had already described as the worst in a generation took a turn for the worse after the quarter ended," he said, citing even higher defaults and sharper declines in home prices.

Industry analysts see a heightened possibility that the federal government will be forced soon to bail out Fannie Mae and Freddie Mac -- an action that might halt or slow this downward spiral.

In a rare display of bipartisanship this summer, the Bush administration and Congress quickly came together on a rescue plan that would prop the companies up if they faced imminent collapse. Treasury was given the authority to lend Fannie Mae and Freddie Mac money or buy stakes in the firms.

Deborah Lucas, a finance professor at Northwestern University, said the government's rescue plan was designed to restore confidence in the companies and the financial markets, of which the mortgage market is a significant part. "The motivation for the bailout was to prevent that type of spiral," she said.

So far it has not worked out that way. "Their ability to lend is constrained by their insufficient capital, higher spreads and investor doubts about whether they will be allowed to continue to operate in a business-as-usual mode," Lucas said.